IRS Issues LMSB Directive on Nonperforming Loans

Background / Strategic Importance

The issue of non-performing loans was the subject of a Coordinated Issue Paper (CIP) dated October 31, 1991. On May 21, 2007, Rev. Rul. 2007-32, 2007-1 C.B. 1278, and Rev. Proc. 2007-33, 2007-1 C.B. 1289 were issued regarding the position of the IRS on the tax treatment of interest income on non-performing loans. Subsequently, the issue of non-performing loans was designated a Tier II Issue by LMSB. The Issue Owner Executive (IOE) is Rosemary Sereti, Acting Director, Field Operations (Manhattan), Financial Services. IRM 4.51.1.3 requires issue coordination under direction of the IOE.

In recognition of the strategic importance of this Tier II issue, Financial Services created an Issue Management Team (IMT) to improve Service-wide coordination of the issues that arise from non-performing loans. The IMT was formed to help identify, develop, and resolve cases with these issues. A primary purpose of the IMT is to ensure that when these issues are identified for audit, they are examined fairly and consistently for all taxpayers. The IMT also plays a key role in providing guidance and technical support to the field on issue development and resolution.

Issue

This Tier II issue typically involves when a regulated bank can stop accruing interest on non-performing loans for tax purposes. In addition, we need to be concerned with the treatment of accrued but unpaid interest and the application of any subsequent payments after a bank places a loan in non-accrual status for regulatory purposes.

Overview

The timing of when a regulated bank can stop accruing interest on non-performing loans for tax purposes involves a difficult and time consuming loan-by-loan analysis, which was previously the subject of a Coordinated Issue Paper. Factually, interest should only stop accruing on non-performing loans for tax purposes when, at the time the interest becomes due, that interest is determined to be uncollectible or the underlying loan is determined to be worthless.

In addition to when a regulated bank can stop accruing interest on non-performing loans for tax purposes, we need to be concerned on audit with the treatment of accrued but unpaid interest and the application of any payments after a loan is placed in non-accrual status for regulatory purposes, since some regulated banks may be following regulatory accounting for tax. Specifically, once a loan is placed in non-accrual status for regulatory purposes, some regulated banks may be reversing any accrued but unpaid interest for both regulatory and tax purposes, instead of continuing to include this interest in income as required for tax purposes. Also, some regulated banks may be applying any subsequent payments on their non-accrual loans to principal, instead of applying these subsequent payments first to any outstanding interest as required for tax purposes.

On May 21, 2007, Rev. Rul. 2007-32, 2007-1 C.B. 1278, and Rev. Proc. 2007-33, 2007-1 C.B. 1289, were published to deal with the above issues. Specifically, Rev. Rul. 2007-32 reaffirms the Service's position of what the tax law is regarding the accrual of interest on non-performing loans by regulated banks. Also, under the facts of this revenue ruling, a regulated bank under the conformity election for bad debts as provided for in Treas. Reg. Sec. 1.166-2(d), stops accruing interest on loans placed in non-accrual status for regulatory purposes and gets a bad debt deduction for previously accrued but unpaid interest, when that interest is reversed for regulatory accounting purposes. Under Rev. Proc. 2007-33, regulated banks can now elect a safe harbor method of accounting where they can limit the amount of unpaid interest on non-performing loans they have to accrue for tax purposes based on a "recovery percentage".

Discussion

Rev. Rul. 2007-32 requires that an accrual method bank with a "reasonable expectancy" of receiving future payments on a loan must include accrued interest (determined under Treas. Reg. Sec. 1.446-2(a)(2)) in gross income for the taxable year in which the right to receive the interest becomes fixed, notwithstanding bank regulatory rules that prevent accrual of the interest for regulatory purposes (i.e. loan placed in non-accrual status for regulatory purposes). This ruling also states that when an income item is properly accrued and subsequently becomes uncollectible, a taxpayer's remedy is by way of a bad debt deduction under section 166, rather than through elimination (i.e. reversal) of the accrual. Furthermore, this tax rule is applicable even when the item of income is accrued and becomes uncollectible during the same taxable year. Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934).

Rev. Rul. 2007-32 also states Treas. Reg. Sec. 1.446-2(e) generally provides that each payment made on a loan is treated first as a payment of interest to the extent of any accrued interest that is uncollected on the date the payment becomes due. Similarly, the interest characterization provided for in Treas. Reg. Sec. 1.446-2(e) would apply to a payment on a loan for which the uncollected accrued interest was previously recognized as income for federal income tax purposes and subsequently deducted as a worthless debt under the taxpayer's method of accounting.

Finally, Rev. Rul. 2007-32 provides guidance as to the period in which a regulated bank that has elected the conformity method of accounting for bad debts under Treas. Reg. Sec. 1.166-2(d)(3) can treat uncollected accrued interest as worthless for tax purposes. Specifically, under the facts of this revenue ruling, a regulated bank under the conformity election can stop accruing interest on any loans placed in non-accrual status for regulatory purposes and is entitled to a bad debt deduction for previously accrued but unpaid interest, when that interest is reversed for regulatory accounting purposes. Furthermore, this treatment of accrued but unpaid interest would apply to loans placed in non-accrual status for regulatory purposes, even if the underlying loan, itself, cannot be charged off as a bad debt for tax purposes at that time.

Rev. Proc. 2007-33 provides the exclusive procedure by which an accrual method regulated bank may obtain the Commissioner's consent to change its method of accounting for uncollected interest (other than interest described in Treas. Reg. Sec. 1.446-2(a)(2)) to the safe harbor method provided in the revenue procedure. Specifically, under Rev. Proc. 2007-33, regulated banks can now elect a safe harbor method of accounting where they limit the amount of unpaid interest on non-performing loans they have to accrue for tax purposes based on a "recovery percentage".

Issue Tracking

Cases identified having this issue should use the following UIL and IMS Issue Tracking Codes:

• UIL Code -- 451.11-03 -- Accrued Interest on Non-Performing Loans

• IMS Issue Tracking Code -- 2370 -- Non-Performing Loans

This issue of non-performing loan should be considered on all examinations where the taxpayer is a regulated bank, which utilizes the accrual method for tax accounting purposes. Due to the current economic conditions, non-performing loans are likely to be present on all regulated banks. During the risk analysis process, examiners should become familiar with Rev. Rul. 2007-32 and Rev. Proc. 2007-33

Once examiners have made a determination that the issue warrants further consideration, materiality thresholds should be established. If the issue is selected for examination, agents should contact the Banking Technical Advisor for advice and assistance to ensure consistent and uniform treatment of this issue.

Audit Techniques

In the consideration of income tax returns of regulated banks, the following techniques should be considered:

• Schedule M-3 should be reviewed to determine if there is an adjustment increasing taxable income for the accrual of interest on non-performing loans.

• The CAS should be contacted to develop a strategy to identify payments made by customers.

• Examiners should issue an IDR which contains the questions presented on Attachment A to this Memorandum.

Any questions regarding this Directive may be addressed to the Commercial Banking Technical Advisors, Jeffrey Kammerman and William Coe or to Banking Industry Counsel, Vincent Guiliano.

This Directive is not an official pronouncement of law or the position of the Service and can not be used, cited, or relied upon as such.

Attachment A -- IDR for Non-Performing Loans

cc: